How much do stocks really return?

Chris Tobe, CFA, CAIA is a top expert on pension and 401(k) investing and is
an Senior Investment Consultant with the Hackett Group. He has been quoted
frequently on Stable Value in 401(k)s in the Wall Street Journal, Barron’s and
dozens of trade magazines and is working on a book on Stable Value. His recent
book on public pensions “Kentucky Fried Pensions” has been featured in the New
York Times and Rolling Stone.

As of the end of January 2013, the 1-year return of the S&P 500 stock index was 16.78%; for 3 years, 14.14%; for 5 years, 3.97%; and for 10 years, 8.35%. But most experts agree you need to look at much longer time periods to get a real sense of how stocks perform. The answer of course is murky: At the market’s top in 2007 some were saying 12% average long-term returns, while now you hear as low as 6% for long-term expectations on stock returns. One thing is certain: Returns have to be higher than money markets (or certificates of deposit) or no one would ever invest.

In recent years this debate on long-term stock returns has turned very political with regard to public pensions, very much like that of interest rates that I covered in my last column, “Inconvenient truths and interest rates.” Most state pensions have overall return assumptions of 7.5% to 8% annually, and to have this they must have equity assumptions of 8% or more. As a trustee with the Kentucky Retirement System, I suggested that we lower our assumed rate from 7.75% to 7.5% on our 27% funded plan for liquidity reasons, and I was shot down because it would have driven a higher contribution.

I think there are three driving political forces behind the outlooks on overall rate assumptions and stocks: conservatives, liberals, and Wall Street, which has both Democrats and Republicans. Conservatives are pushing for a lower overall rate to reflect what they see as the true cost and to make a better case to shrink government spending by cutting benefits or at least denying cost of living adjustments (COLAs).

Liberals and employee groups are defending the current overall rate to prevent more pressure on lowering benefits and COLAs. Wall Street wants to keep the current overall return assumptions, but wants to lower the equity assumption to 8% or less, which essentially would force public plans into more high-fee private-equity and hedge funds. So far in this debate both public employees and taxpayers are losers, while the only winner is Wall Street.

This debate has been going on for a while. In 2007, Warren Buffett in his annual report commented that public pensions would have a tough time getting 9% after fees needed on equity and alternatives. In 2006 the Department of Labor under President George W. Bush justified target-date return products in 401(k)s by using long-term stock assumptions of 10.4% based on 78 years of data. Recently New York City Mayor Michael Bloomberg commented that he thought 7% to 8% assumptions were too high.

Another probably more helpful way to look at equities is with their premium over bonds. The current near-zero rates make stocks look very attractive. The DOL in justifying their 10.4% equity returns also assumed a 3.7% bond return, which equates to an equity risk premium of 6.7%. Many think the equity risk premium has to be at least 4%. If interest rates stay near the current level, then an 8% return on stocks is great, and even a 6% return is OK. However, if interest rates go up, then 10% might be too low.

In the long haul, the ownership represented by stocks has to return greater than debt represented by bonds. The exact number really is not that important, only the fact that the return is materially higher than that of bonds, which means investors are better off with some allocation to stocks. Acceptable ranges for any pension—including a 401(k)--are 30% to 80%, but never 0% or 100%. No matter what you hear on the TV, read on the Internet or hear from your friends, you should always have some exposure in the stock market.

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